OFS Capital Corporation 4.95% Notes due 2028 (OFSSH) Q3 2021 Earnings Report, Transcript and Summary

Good morning. And welcome to the OFS Capital Corporation Third Quarter 2021 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Steve Altebrando, VP of Capital Markets. Please go ahead.

Good morning, everyone, and thank you for joining us. Also on the call today is Bilal Rashid, Chairman and Chief Executive Officer of OFS Capital; and Jeff Cerny, the Company’s Chief Financial Officer and Treasurer. Please note that we issued a press release this morning announcing our third quarter 2021 results. This release was subsequently filed on Form 8-K with the SEC. Both documents can be obtained under the Investor Relations section of our website at ofscapital.com. Before we begin, please note that statements made on this call and webcast may constitute forward-looking statements as defined under applicable securities laws. Such statements reflect various assumptions, expectations and opinions by OFS Capital management concerning anticipated results are not guarantees of future performance and are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from such statements. The uncertainties and other factors are in some way beyond management’s control, including the risk factors described from time to time in our filings with the SEC. Although we believe these assumptions are reasonable, any of those assumptions could prove inaccurate, and as a result, the forward-looking statements based on those assumptions also could be incorrect. You should not place undue reliance on these forward-looking statements. OFS Capital undertakes no duty to update any forward-looking statements made herein, and all forward-looking statements speak only as of the date of this call. During this call, we will be referring to non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in the Investor Relations section of our website at ofscapital.com, under the heading Tax and Non-GAAP Information. With that, I’ll turn the call over to Chairman and Chief Executive Officer, Bilal Rashid.

Thank you, Steve. Good morning, everyone. We appreciate you joining us today and hope that you and your families continue to be healthy and safe. We had another solid quarter. Here are the key takeaways. Our net asset value increased 5.5% from the second quarter to $14.16. This represents a 14% increase from the fourth quarter of 2019, the last quarter before the pandemic interrupted U.S. economic activity. We increased our quarterly distribution to $0.25 per share, marking our fifth consecutive quarterly distribution increase. Net investment income was $0.24 per share, in line with the second quarter. Adjusted net investment income was $0.25 per share, an increase of more than 4% compared to the second quarter. We had no new loans on nonaccrual in the quarter. In fact, we have not placed any loans on nonaccrual since the second quarter of 2020. In October, we closed a $50 million seven-year unsecured bond offering with an attractive coupon of 4.95%. In fact, so far this year, we have issued $180 million of unsecured long-term bonds to refinance existing bonds, which reduces our borrowing costs and extends the maturity of our bond debt. We expect that the bond refinancings will help increase our earnings and further strengthen our balance sheet. The increase in our net asset value continues to be aided by improvements in the performance of our debt investments and strong growth in our equity investments. As we discussed last quarter, one of these equity investments, Pfanstiehl, a global manufacturer of high-purity pharmaceutical ingredients, continues to perform well. While we primarily invest in senior secured loans, our investment strategy allows us to selectively make equity investments when we identify a strong opportunity. We believe that our asset selection before and during the pandemic, along with the strength of our balance sheet has enabled us to successfully navigate this unprecedented situation. We also relied on the experience of our adviser, which has worked through multiple credit cycles and global economic disruptions over the last 25 years. We believe the resiliency of our portfolio through the pandemic is a testament to our longstanding underwriting process. Since our IPO, we have invested $39.1 million in the equity or received warrants in more than 38 portfolio companies. To date, we have net realized gains of approximately $19.5 million on $16.5 million of invested capital. This equates to a multiple of invested capital of 2.2 times for realized investments. As of September 30th, the remaining $22.6 million of capital still invested in our portfolio companies has a net unrealized gain of approximately $50.5 million. This equates to a multiple of 3.2 times for unrealized investments. Our fundamental priority is to remain focused on preserving capital while thoughtfully growing our earnings. We believe that our portfolio remains defensively positioned, both in terms of seniority in the capital structure and industry selection. As a percentage of fair value, approximately 95% of our loan portfolio was senior secured at the end of the third quarter. Our portfolio is diversified across multiple industries with significant exposures in health care, technology, business services and manufacturing. In addition, we continue to avoid highly cyclical industries such as oil and gas, metals and mining. Our loans are largely floating rate and our financing is primarily fixed rate. Therefore, we view our portfolio as being well-positioned to benefit from an eventual increase in interest rates. Looking forward, we anticipate that the broader economy will continue to improve over time due to supportive fiscal and monetary policies for growth. These steps continue to drive overall M&A activity and the need for debt capital to finance this level of deal-making activity, which should remain robust. We have been actively reviewing potential investments from new borrowers as well as existing borrowers, which consider OFS Capital a trusted capital provider. We made $64.7 million in investments in the third quarter which was an increase of 7% from the second quarter. This brings the total for investments this year to $193.5 million. Our origination activities have been increasing steadily since the beginning of this year. While always highly selective, we see the current conditions as a solid backdrop to deploy capital, which we anticipate will lead to an increase in our net investment income in the long term. Our financing continues to provide us operational flexibility. As of the quarter’s end, more than 92% of our debt matures in 2024 or later and nearly two-thirds of our debt is unsecured. In addition, our senior loan facility matures in 2024 and is nonrecourse to the BDC. Our corporate line of credit is flexible with no mark-to-market provisions. OFS Capital continues to benefit from the expertise and scale of its adviser. With more than $2.8 billion in assets under management, the BDC adviser has experience investing across the known and structured credit markets, which helps us to identify relative value credit opportunities across multiple asset classes. Our team of investment professionals has extensive experience in credit underwriting and restructuring across industry verticals. We consider our broad investment platform and expertise across multiple asset classes and industries to be beneficial in this current market environment, where we are seeing increased competition to effectively deploy capital. In addition, we believe that shareholders benefit from our alignment of interest with the adviser owning 22% of the outstanding shares of the BDC. You can be assured that we are working diligently every day to protect our investments and drive the business forward for the benefit of all shareholders. At this point, I’ll turn the call over to Jeff Cerny, our Chief Financial Officer, to give you more details and color for the quarter.

Thanks, Bilal. Good morning, everyone. As Bilal just discussed, we continue to be encouraged by the overall performance of our portfolio companies and the increase in the fair value of our debt and equity investments, driving a 5.5% increase in our net asset value over the prior quarter. Our net asset value per share now stands at $14.16, which is more than 14% above our pre-pandemic net asset value at the end of fiscal year 2019. Turning to our results. At quarter’s end, we had approximately $70 million in outstanding SBA debentures compared to approximately $203 million in cash and investments at fair value in our SBIC. We believe this provides a meaningful equity cushion of approximately $133 million compared to our initial investment in the SBIC of approximately $75 million. We feel good about the composition of our liabilities. Since quarter-end, we’ve issued approximately $55 million of new lower-priced unsecured debt, which we anticipate will result in a reduction in our borrowing costs. As Bilal mentioned, 92% of our debt matures in 2024 or later and 64% of our outstanding debt at quarter-end was unsecured. Excluding our SBIC debt, our debt-to-equity ratio was stable quarter-over-quarter at approximately 1.3 times. As we mentioned, our net asset value continues to show a strong recovery since the onset of the pandemic. The increase was primarily driven by higher fair value marks on our debt and equity investments, especially as Bilal discussed, the increase in our unrealized gain on our equity investment in Pfanstiehl. We had no new nonaccruals this quarter. We have not had a new nonaccrual since the second quarter of 2020. At fair value, we currently have 2.1% of the loan portfolio on nonaccrual. Turning to the income statement. Total investment income for the quarter decreased approximately $825,000 from the second quarter to $10.6 million. This was primarily due to a decrease in the weighted average yield on our portfolio, lower syndication fees and accounting for prepayments and amendment fees. Total expenses of $7.4 million were down approximately $800,000 from the prior quarter. This decrease was primarily attributable to lower incentive and administrative fees. Net investment income of $0.24 per share was in line with the second quarter. Adjusted net investment income was $0.25 per share, an increase of more than 4% compared to the second quarter. As Bilal discussed, earlier this morning, we announced the distribution for the fourth quarter of $0.25, an approximate 4% increase in the quarterly rate. The Board approved this higher distribution, based in part on our increased adjusted net investment income and our earnings expectations. We believe our most recent bond offering will help improve our overall earnings and better optimize our capital structure. As always, we remain focused on our liquidity and maintaining a healthy balance sheet. Turning to our investments. We are pleased that our portfolio companies have continued to perform, and continue to have confidence that our underwriting selectivity will increase the likelihood that the portfolio performs positively in the future. Several of our portfolio companies continue to identify opportunities for growth for which we are evaluating incremental funding. The majority of our investments are in loans. 95% of the fair value of our loans were senior secured, 97% of which were floating rate. We had LIBOR floors on approximately 86% of our floating rate loan portfolio with a weighted average LIBOR floor of 0.96%. In the current interest rate environment, this LIBOR floor continues to be a strong contributor to our earnings as it favorably compares to the three-month LIBOR of just 13 basis points at September 30th. Our overall investment portfolio, as a percentage of cost, includes approximately 77% senior secured loans, 2% subordinated debt, 15% structured finance notes and 6% equity, of which approximately half of our equity was in preferred equity securities. Our portfolio remains diversified. At the end of the quarter, the portfolio had investments in 100 companies totaling approximately $526 million on a fair value basis, with an average investment in each portfolio company of $5.3 million or 1% of the portfolio’s total fair value. The overall weighted average yield to cost on our performing debt and structured finance note investments is 9.64%, down by 13 basis points quarter-over-quarter, primarily as a result of our continued focus on first lien debt to larger companies. With that, I’ll turn the call back over to Bilal.

Thank you, Jeff. In closing, we are pleased with our performance in the third quarter. Our net asset value has continued to grow, driven by the performance of both, our debt and equity investments. Our net asset value is 14% above its level at the end of 2019 before the pandemic began. Once again, we increased our distribution, reflecting our view of the improved performance and our expected outlook for the quarters ahead. Since the beginning of 2011, OFS has invested approximately $1.6 billion with a cumulative net realized loss of principal of only $24.7 million on a cumulative loss rate of only 1.3%, while generating attractive yields on our portfolio. Over time, we have been steadily increasing our allocation to senior secured loans, which now constitute the majority of our known portfolio. Our financing is primarily long term with 90% of our debt maturing in 2024 and beyond, and 64% of our outstanding debt was unsecured. We believe that this gives us operational flexibility to execute on our business plan. Lastly, we believe the size, experience and repetition of our adviser has continued to benefit our business. With a $2.8 billion corporate credit platform within a more than $30 billion asset management group, our adviser has broad resources, including long-standing banking and capital markets relationships. It has gone through multiple credit cycles over the past 25 years, and it has a strong alignment of interest with a large ownership interest in the BDC. Before we go, I want to make sure to thank all our employees for their continued hard work, especially through this evolving pandemic. Their dedication and diligence has been invaluable to our ability to navigate this challenging time. With that, operator, please open up the call for questions.

[Operator Instructions] Our first question comes from Mickey Schleien with Ladenburg.

Yes. Good morning, everyone. Based on the second quarter’s Q, we obviously haven’t seen the third quarter yet, you had about 10% of the portfolio in loans with spreads below 500 basis points, which are relatively low yields. And some of those were added relatively recently. Could you give us the investment thesis for holding those lower-yielding assets in the BDC?

Sure. So, Mickey, as you know, we set up this senior loan facility a little while ago. And those assets -- those lower-yielding assets are in that senior loan facility on which we’re charging a lower management fee as well. But those assets -- our expectation is that over time, we are going to rotate -- our plan is to rotate out of those lower-yielding assets and replace them with higher-yielding assets. So, we didn’t want to sit on cash or have that facility to be not utilized. So, our expectation is that we would over time rotate out of them and replace them with higher-yielding assets?

Thank you for that. I do understand your explanation. Thank you. Bilal, over what period of time do you expect to unwind the SBIC? And where do you see your overall leverage ending up in current market conditions when that unwinding is complete?

Sure, Mickey. So, I think that it’s hard to predict how long it will take for the SBIC to unwind. I can give you a sense that over the last 18 months or so, we have paid down approximately $80 million of the $150 million of that debt outstanding. So, that’s sort of the history there. And so, I think the wind-down really will depend on how quickly we get prepayments, et cetera, which is hard to predict at this point. But we -- you can certainly look at the history of the paydown and how long it took us to pay down $80 million, and we have approximately $70 million now left on that.

So, -- I’m sorry.

And then, I think, in terms of the target leverage, I mean, our expectation is that the regulatory leverage and the overall GAAP leverage are going to converge over time as we pay down the SBIC. And the target there, sort of a long-term target from a regulatory and GAAP leverage, once they do converge, would be in the 1.3, 1.4 times debt-to-equity.

Thank you for that, Bilal. And what sort of deal flow do you expect to focus on as the SBIC unwinds, and as you rotate those lower-yielding assets in terms of the sourcing channels and the size of the borrower that you’re pursuing going forward?

Sure. So, the deal flow -- a lot of the deal flow is coming for us these days through the private equity channels. We have relationships with lower middle market private equity firms. We do also have the ability to -- and the sourcing capability to do non-sponsored transactions as well, and we have relationships to source those deals as well directly from the borrowers and in many cases, through financial intermediaries. And the focus for us is not the really lower part of the middle market, which was where we had a lot of the SBIC types of assets. We’re generally looking at $10 million to $30 million EBITDA companies, and generally focusing on senior secured loans and the -- so I think that’s kind of the target for us, companies with, let’s say, between $10 million and $30 million of EBITDA and senior secured loans, mostly private equity-backed companies, but also looking at non-sponsored deals as well, if it makes sense.

Bilal, in that situation, are you talking about, let’s say, L plus 600 to perhaps L plus 800 on first lien deals?

That’s sort of the range, I would say, on those kinds of deals. And we get floors as well and points upfront.

True, true. Last question. You had another strong quarter of unrealized appreciation, as you mentioned in the remarks. And the portfolio’s valuation, if I’m not mistaken, when you look at fair value over cost, is at a record level. I think, you said most of that is being driven by company performance as opposed to valuations. Looking forward, do you think there’s more upside in the portfolio’s valuation, or when we look at the economic cycle and the credit cycle, do you think we’re sort of achieving full valuation on these investments?

Hey Mickey. This is Jeff. How are you.

Hi, Jeff.

Hello. Good morning. As you know, debt investments kind of generally move up and down in a fairly tight band. We do think there’s continued additional upside within our equity portfolio. And you’re right, the fair value of our investments today exceed the amortized cost. So, we’re quite happy with the performance of the portfolio. And the gains have largely been driven by strong performance in the overall portfolio.

Thank you for that, Jeff. That’s helpful. Those are all my questions this morning. I appreciate your time, as always.

Thanks, Mickey.

This concludes our question-and-answer session. I would like to turn the conference back over to Bilal Rashid for any closing remarks.

Thank you all for joining our call today. And we look forward to speaking with everyone again next quarter. Operator, you may now end the call. Thanks.

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.